Speech Monetary Policy and the Regions

Thank you for the invitation to come to Shepparton. No one knew, when the invitation
was issued almost a year ago, that you would be battling floodwaters just a
couple of weeks prior to today. It is good to see the recovery already well
advanced.

In the global economy, recovery from the effects of a different kind of deluge
– a man-made one – has been under way for a while. Progress has
been quite varied, however, and the outlook is uncertain just now. I will give
an update on those matters today.

It also seems a fitting occasion to talk about ‘monetary policy and the regions’,
since a question we are often asked is how we take account of differing economic
conditions across the country in the setting of monetary policy. I will offer
some perspectives on the issues that arise when we have one policy instrument
for a fairly diverse economy. The essential message here is that such diversity
matters, but is often not as pronounced as people assume, because all the parts
of the economy are ultimately connected. Things that affect one sector tend
to have spillover effects elsewhere. Furthermore, economies have a certain
capacity to adjust to differing conditions. In Australia this works reasonably
well.

Current Economic Conditions

The global economy continues to present a mixed picture. In the Asian region, most
countries have well and truly recovered from a downturn that occurred in late
2008 and the first few months of 2009. The main exception is Japan. In the
bulk of cases, economies are much closer to their potential output paths now
than they were a year ago and policies are moving to less expansionary settings.
As a result, over the year ahead the growth in the Asian region is unlikely
to be as rapid as over the year to mid 2010, when the ‘v-shaped’
recovery was in full swing. Similar comments could probably be made about Latin
America.

In Europe, the German economy has been powering ahead this year, reaping the
benefits of many years of attention to containing costs and building productivity.
But other continental economies are not as strong, and some are in the grip
of a very painful adjustment to a world of constricted private credit and limits
to budgetary flexibility. In the United States an expansion has been under
way for some time, but seems lately to have been losing a bit of steam and
growth has recently not been robust enough to reduce high unemployment.

In Australia, growth has been quite solid over the past year, unemployment is
relatively low, and inflation has, for the moment, declined. In fact, growth
trends have been favourable over several years now in comparison with many
other economies.

The charts below, comparing trends in Australia's real GDP per capita
with that of several countries, are illustrative. Of course we cannot match
the extent of growth in China – a country where living standards are
rapidly increasing in a process of ‘catch up’ to the higher levels
of high-income countries (Graph 1). But it is clear that compared with
the US or Europe, or Japan, Australia's per capita output and income
has done pretty well over the past several years (Graph 2).

Graph 1

Graph 2

The task ahead, then, is to seek as far as possible to continue a solid trend
like this, through various challenges which lie ahead. The future is of course
unknowable, and economic forecasts unfortunately are not very reliable. But
we have no option but to try to form a view of how things will probably unfold.

We think the global economy will record reasonable growth over the coming year,
though not as strong as the past year (a strength that, incidentally, surprised
most observers). We think Australia's terms of trade, after reaching
a 60-year high in the current quarter, will probably decline a bit, but remain
high. We expect that this high level of relative export prices will add to
incomes and spending, even as the stimulative effects of earlier low interest
rates and budgetary measures continue to unwind. We expect, and indications
from businesses are that they do as well, that resource sector investment will
rise further – as we experience the largest minerals and energy boom
since the late 19th century. Even with continued caution by households, that probably
means that overall growth, which has been at about trend over the past year,
will increase in 2011 to something above trend. We think that means that the
fall in inflation over the past two years won't go much further.

Of course that central forecast could turn out to be wrong. Something could
turn up – internationally or at home – that produces some other
outcome. We spend a fair bit of time thinking about what such things could
be. Possible candidates might be a return to economic contraction in the United
States, or a bigger than expected slowdown in China, or the resumption of financial
turmoil that abruptly curtails access to capital markets for banks around the
world and damages confidence generally. But if downside possibilities do not
materialise, the task ahead is likely to be one of managing a fairly robust
upswing. Part of that task will, clearly, fall to monetary policy.

The Objectives of Monetary Policy

What then are the objectives of monetary policy? Put simply, our job is to preserve
the value of money over time and to try, so far as possible, to keep the economy
near its full employment potential. Over the long run, these are mutually reinforcing
goals, not conflicting ones. For the past 17 years the way we have pursued
these goals has been to operate a medium-term target for CPI inflation of 2–3
per cent, on average. The ‘on average’ specification allows us
to accept short-term fluctuations in inflation – as long as they are only short-term – and so avoid the risk of attempting to
over-control inflation and in the process de-stabilising the economy. But the
specification still requires us to limit inflation in the medium term. Over
the 17-year period, CPI inflation has averaged 2.5 per cent (excluding the
one-time impact of the GST in 2000), and the economy generally has exhibited
more stability, with real GDP mostly a little closer to trend than it had been
in the preceding couple of decades.

How Does Monetary Policy Work?

The Reserve Bank has very effective control over one interest rate – namely
the rate that applies when one financial institution lends cash overnight to
another hence the label the ‘cash rate’). This rate has a major
impact – though not to the exclusion of other forces – on a range
of short-term market rates. Since the bulk of financing activity in Australia
is contracted on variable interest rates that are axiomatically affected by
changes in short-term rates, the rates paid by borrowers are usually closely
affected by cash rate decisions – though other factors can impinge as
well from time to time. Through this device the Bank can affect the relative
incentives for saving versus borrowing, and so have an impact on spending on
goods and services and on financial and ‘real’ assets. Because
the relative rates of return on Australian assets compared with foreign assets
are altered when we change interest rates here, the exchange rate also moves
in response to monetary policy changes (although most of the time it is moving
in response to a host of other factors as well).

Often, the expectation of what will happen to the cash rate in the future is just
as important as, or even more important than, the level of the cash rate today.
For this reason what the Bank says – or what people think we have said
– can be very influential on markets and behaviour. It is for this reason
that central bankers are usually so guarded in public comments.

The Effects of Monetary Policy in a Diverse Economy

It is obvious even from the above highly condensed description that monetary
policy will affect different groups in different ways. For a start, changing
interest rates shifts the distribution of income between savers and borrowers.
The larger the size of one's balance sheet – either assets or debt
– the more likely one is to be affected by a change in rates of interest.
Someone with no debt and no savings will probably feel little impact –
if they feel anything at all – of a change in interest rates, at least
directly.

In addition, we only have one set of interest rates for the whole Australian
economy; we do not have different interest rates for certain regions or industries.
We set policy for the average Australian conditions. A given region or industry
may not fully feel the strength or weakness in the overall economy to which
the Bank is responding with monetary policy. In fact no region or industry
may be having exactly the ‘average’ experience. It is this phenomenon
that people presumably have in mind when they refer to monetary policy being
a ‘blunt instrument’.

The issue is that it is not possible to have different monetary policies by
region or by industry within the country, at least not while we are all using
one currency and funds are free to flow around. Either each area that wanted
its own interest rate would also have to have its own currency, or there would
need to be a draconian set of regulations to prevent savings in one region
flowing to another to be loaned out – a sort of local and regional equivalent
to the pervasive capital controls which once existed on international capital
movements. Quite possibly both of the above might be needed for a comprehensive
tailoring of interest rates to each set of local conditions. Obviously that
is unlikely to be practical.

Moreover there would be costs for a region having its own currency. It would
have to establish its own Reserve Bank for a start, and would have to accept
additional transactions costs for cross-border transactions with other regions,
which would probably inhibit trade and investment flows with other regions
in its own country. Very small currency areas have also often got into trouble
over the years. These are reasons why many very small countries often peg their
currency to that of a larger neighbour or simply adopt that currency outright.
Perceived gains from being part of a larger monetary union have continued to
attract small European countries to the euro, even though the membership conditions
are fairly demanding, as we have recently seen.

There is a field of economics that thinks about this set of issues. Apart from
the obvious criteria like language, culture and political unity, a suitable
case for a single currency is thought to be stronger when:

the forces (‘shocks’) that affect a group of regions or countries
are fairly similar and the way in which the regional economies respond is
similar;

there is a lot of trade between the regions (as there usually is within a single
country);

factors of production (labour and capital) flow fairly easily between the regions
in response to differences in conditions; and/or

when other means for responding to differences in experience (particularly fiscal
transfers) are available.

That framework suggests several questions we might ask for Australia and its regions:

How different are the shocks by region?

How flexibly does the economy respond to such differences?

What other policy mechanisms are at work to respond?

And finally, how different, ultimately, are the experiences after these responses
have occurred?

Differences Across the Country

It is worth observing that not all ‘shocks’ that hit the economy
have markedly different effects by region or industry. Some of them are fairly
widespread in their effect.

Take the sudden intensification of financial turmoil in September 2008. Confidence
slumped and people began to ‘batten down the hatches’ – in
just about every industry and every region around the world – more or
less simultaneously. Banks became more cautious in lending – most particularly
to the property sector, but generally to almost all borrowers – in every
country.

Other shocks are more particular. The one most people would think likely to
have a differential impact across regions would be the big rise in mining prices
and associated build-up in investment that we saw a few years ago, and which
has returned over the past year and a half. Since the mineral resources are
not found in abundance in every region, some areas would be expected to receive
more of a boost than others. For example in Western Australia, mining accounts
for a quarter of production; it is only 2 per cent of production in Victoria.
So it would seem obvious that the impact of an event that increases the demand
for minerals is likely to see, in time, the output of WA given more of a boost
than that of Victoria.

But as usual, the picture gets more complicated when we think further. The headquarters
of some major mining companies are in Melbourne. Those companies will be putting
additional demand on various service providers around the nation – from
air travel to consultants, from geologists to manufacturers, and so on. The
effects of the engineering and construction build up for some of the minerals
investment will be felt in other regions around the country (and indeed also
by overseas suppliers). The higher incomes generated from the mineral boom
will be felt by employees, shareholders (some of whom are overseas) and by
governments (via various taxes). Depending on how these entities respond to
these gains in income, there will be subsequent effects on economic activity
around the country. It may well still be the case that the effects are most
obvious and most pronounced in WA, but there will be substantial spillovers
as the economy responds. Incidentally, most data suggest that until quite recently
economic activity was growing faster in Victoria than in WA.

So to the second question, how about the mobility of factors of production?
A remarkable feature of some of the remote area mining operations is the way
the labour operates on a ‘fly-in, fly-out’ basis. Any user of Perth
airport can easily attest to this but the ‘commutes’ also occur
from the eastern states. More generally, population shifts have long been occurring
between the south-eastern states and the resource-rich states. While moving
is costly, in most analyses I have seen the mobility of the Australian workforce
is pretty good – people shift in response to opportunity. Capital is
of course highly mobile, at least at the margin.

As for other policy mechanisms at work, there are substantial fiscal transfers.
The ‘automatic stabilisers’ will take more taxes from regions that
are doing well, since incomes will be rising relatively quickly, and transfer
it to areas doing less well in the form of welfare payments. Governments can
also use discretionary spending or other policies as part of this. Moreover
there are structures in place that are deliberately designed to lessen systematically
the differences in outcomes which might otherwise occur.

Opinions will differ about how effective these have been, and about how effective
they should be – as recent political events have probably demonstrated.
But the general point is that in a political federation such as Australia,
there are various fiscal transfer mechanisms that act to diminish the divergences
that might result from differences in initial conditions and exposure to economic
events. This is likely to be less so in an area which is a monetary union but
not a political federation. Indeed some economists have long pointed to this
as a potential difficulty for the euro area in some sets of circumstances,
like the ones that exist in Europe at present. That said, we are seeing, albeit
on a somewhat ad hoc basis, more intra-European transfer mechanisms being developed.

So for Australia, the effects of a ‘shock’, even if concentrated
initially, will tend to be felt more generally across the economy over time.
The way the economy works will naturally tend to help this occur, as will various
other policy devices. That is what is supposed to happen in a well-functioning,
integrated national economy.

The next question, then, is how different outcomes turn out to be after all
these mechanisms have responded to the various impacts. Of course differences
will remain at the industry level – ultimately, it looks likely that
the mining sector and the areas that supply it will grow, and some other industries
will, relatively, get smaller. And at this point, much of the impact of the
recent resource price changes is yet to be seen. Nonetheless it is still worth
examining just how different key trends have been to date across regions.

There are various indicators at a state level and even a regional level. These
are of varying reliability – sample sizes get pretty small in some cases.
Two of the more reliable data sets are likely to be the consumer price index
and the unemployment rate. It is these, of course, that people are probably
most interested in as well.

The CPI is available only for capital cities. Consumer prices in the capital
cities have tracked remarkably closely (Graph 3) – at least as much
as in other single currency areas like the United States or the euro area (Graphs
4 and 5).

Graph 3

Graph 4

Graph 5

In the case of unemployment rates, a fair bit of disaggregated data is available.
Graph 6 below shows the national unemployment rate and the range across the
statistical regions measured by the ABS for which there are reasonably reliable
continuous time
series[1].
If we weight these unemployment rates by population, the shaded area is where
80 per cent of the weighted observations lie. Recent rates of unemployment
have been between almost zero in the Hunter region (outside of Newcastle) of
New South Wales and about 9 per cent in the far north of Queensland. Eighty
per cent of the population face unemployment rates between 3 and 7 per cent.

Graph 6

Graph 7

Also shown is the dispersion at a state level (Graph 7), which enables
a comparison with the 50 states of the United States, and the 16 countries
of the euro area (Graphs 8 and 9).

Graph 8

Graph 9

These comparisons are affected just now by the fact that the US and Europe have
had deep recessions and are only in an early stage of recovery, whereas Australia
had only a mild downturn and unemployment has been falling for about a year
now. As the charts show, dispersion of unemployment rates does tend to have
a cyclical dimension.

Nonetheless I think it is reasonable, based on the history shown here, to conclude
that, while some events can lead to a divergence in economic conditions across
Australia, overall these differences have not been especially large in recent
times compared with those seen in other entities with whom we might compare
ourselves. That is not to say the differences are unimportant or immaterial
to people's lives, nor that they could not get larger. Nonetheless some
perspective as to how large they actually have been is useful.

How Does the Reserve Bank Keep Track of Different Economic Performances?

That having been said, it is important to add that the Reserve Bank makes considerable
efforts to look below the level of national data in its pursuit of a full understanding
of what is happening on the ground. Over the past decade or so we have put
substantial resources into a comprehensive liaison program with firms, industry
groups and state and regional government entities. Officers based in every
mainland state capital spend much of their time talking to people about what
is going on. Every month they talk to up to 100 organisations around the country.
I know that some of our staff visited Shepparton last month and some of you
may have met them.

The purpose of this is to help us understand what is happening ‘at the
coal face’ – the conditions that businesses are actually experiencing
and the things that concern them. This helps give a richer and often more timely
understanding of what is going on than the higher-level aggregate data alone
might provide. Talking to businesses about their plans for the future helps
inform our forecasts, and has been especially useful recently for building
a profile of conditions in different sectors, such as expected investment in
the mining sector over the coming years. This is important for our analysis
of capacity in, for instance, the mining sector, which affects how we see commodity
prices, the terms of trade, the exchange rate and exports.

Conclusion

As a physically large country, with quite a diverse set of industries, and our
largest population centres separated by long distances and even living in different
climates, Australia is always likely to see some differences in economic experience
by region. What is remarkable, in fact, is that the differences are not, in
the end, larger. That they are not is testimony to the degree of flexibility
within our national economy that has been built up over time, and to the design
of national policies that aim to lessen the more stark differences that might
otherwise occur. Those structures have grown up in the context of a system
of a national money.

Monetary policy is, by design, appropriately a national policy. In conducting
it, the Reserve Bank devotes considerable attention to finding out and understanding
what is happening at the regional and industry level. That helps us to maintain
an overall set of financial conditions that are appropriate for the national
economy. But we know that there will always be some differences in how changes
to monetary policy are felt (though it is not always to be assumed that these
impacts are necessarily greatest in country areas).

Monetary policy can't make those differences disappear. In the end, however,
if monetary policy can help to deliver reasonable macroeconomic stability,
that will offer the best chance for any industry, any region, any business
or any individual to succeed on their merits. The Reserve Bank, taking account
of all the conditions across the various sectors, remains committed to that
goal.

Endnote

In general, the most disaggregated data available have been used. However, the ‘Northern,
Far West-North Western and Central West’ statistical region in NSW
has not been disaggregated, as there have been instances in the past when
the ABS did not publish data for one of its sub-regions. The number
of regions varies with data availability, with two breaks in the series when
the number of regions changed. From November 2007, there are 68 statistical
regions. [1]